Investors hunt strategies in era of ‘repression’

Financial Times

It may be little more than a buzz phrase in the markets but a growing number of strategists believe it accurately encapsulates how sovereign debt markets are being distorted by central bank and government policies that keep interest rates at historic lows.

Chart: Click to enlarge

Real bond yields, those adjusted for inflation, are at their lowest since the 1970s in the US and UK. And if the effect of central bank action is to prevent market mechanisms from responding to inflation, an element of the repression, then this poses big questions for investors’ asset allocation strategies.

Andreas Utermann, chief investment officer at Allianz Global Investors, is unequivocal: “We are clearly in a phase of financial repression. The central banks are clear about it: they are manipulating the capital markets,” he says. “It will mean continual uncertainty.”

For banks, the big worry is that they become the captive buyers of sovereign debt. Indeed, the evidence from Spain and Italy after the European Central Bank’s provision of cheap loans in December and February suggests that is already the case. Much of the billions of euros in cheap ECB money was used to buy eurozone government debt, leading to a fall in bond yields.

At the same time, the search for haven assets, combined with “quantitative easing” in the US and UK, means that yields are well below inflation rates in the government bond markets of America and Britain, as well as Germany. Allianz, the German insurer, holds, largely for regulatory reasons, 90 per cent of its assets in debt instruments, with only 6 per cent in equities.

But, rather than keep pouring money into low-yielding debt, as encouraged by central banks and governments, investors can escape the repression, say strategists. One way out is to opt for equities or corporate credit, so-called risky assets.

“There is a strong argument that when real yields are negative, people look for assets where they can at least get a real return. You want to get closer to real assets rather than IOUs,” says Hans Lorenzen, credit analyst at Citi.

The problem for such a strategy is whether it makes sense over the mid to long term. Mr Lorenzen argues that looking at the last big period of financial repression from the post-war era when there were strong equity returns and low credit spreads in the 1950s and 1960s could be misleading. “For me it is the difference in growth. It was a very different world. Repression wasn’t a problem for returns in risk assets like credit and equities as growth was strong and default rates were low,” he says of that era.

The world today is different. Growth in all developed countries, but especially in Europe, is expected to be mediocre at best while deleveraging or debt reduction is far more widespread through the economy than it was after the war. That may not bode well for risky assets.

Didier Duret, chief investment officer of ABN Amro Private Banking, says an unconsidered move into risky assets is dangerous. “You need to move away from the crowded trades,” he argues. He has been trimming exposure to US equities, investment grade corporate debt – where yields are close to all-time lows – as well as government bonds.

Rather, he suggests assets such as Asian corporate bonds. “You get the same credit rating but you have an additional spread of 30-50 basis points,” he says. In equities he suggests a “barbell” strategy, with cylicals such as Taiwanese companies balanced by defensives such as Malaysian stocks.

Mr Utermann proposes a “simple” two-pronged strategy. The first part is to focus on equities that have strong cash flows and dividends. While critics of this trade point to the large number of strategists recommending it, Mr Utermann says most equity portfolios are constructed at the moment with an anti-dividend bias.

Companies that have maintained dividends have performed poorly – banks and utilities for example – while the best performers such as technology groups have a bad track record on payouts, Apple’s recent announcement notwithstanding. So he recommends ensuring investors have real exposure to dividend companies.

His second piece of advice is to invest in emerging markets equities and bonds without hedging to participate in what he anticipates will be an appreciation of their currencies. “If you believe capital markets will normalise, it will require a fundamental realignment in currencies,” he says, arguing developed countries will see theirs weaken.

The uncomfortable truth for many investors, however, is that financial repression is likely to be a long-winded process with many ups and downs. Mr Lorenzen argues that the two most likely outcomes are a prolonged bout of inflation such as came in the 1970s after the last period of financial repression, or a Japan-style scenario of low growth and choppy markets.

“You can be in a long-term bearish trend but in the periods when monetary policy is being loosened very aggressively you can have these very strong rallies,” he says.

“The difficulty for investors is understanding the relationship between the poor fundamentals and strong liquidity injections. In the long run fundamentals will dominate but at times the liquidity will take over.”

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